NBER WORKING PAPERS SERIES MODERATE INFLATION … · NBER WORKING PAPERS SERIES MODERATE INFLATION Rudiger Dornbusch Stanley Fischer Working Paper No. 3896 NATIONAL BUREAU OF ECONOMIC

NBER WORKING PAPERS SERIES

MODERATE INFLATION

Rudiger Dornbusch

Stanley Fischer

Working Paper No. 3896

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138November 1991

This paper is part of NBER's research program in EconomicFluctuations. Any opinions expressed are those of the authorsand not those of the National Bureau of Economic Research.

NBER Working Paper #3896November 1991

MODERATE INFLATION

ABSTRACT

Inflation persists at moderate rates of 15-30 percent in all

the countries that successfully reduced triple digit inflations

in the 1980s. Several other countries, for example Colombia,

have experienced moderate inflation for prolonged periods. In

this paper we first set out theories of persistent inflation,

which can be classified into those emphasizing seigniorage as a

source of government finance and those that emphasize the costs

of ending inflation. We then examine the sources and persistence

of moderate inflation episodes. Most were triggered by commodity

price shocks; they were brief; and very few ended in higher

inflation. We then present case studies of eight countries,

including three that now suffer from moderate inflation, and four

that successfully moved down to single digit inflation rates. We

examine the roles of seigniorage, indexation and disindexation,

the exchange rate commitment, and monetary and fiscal policy.

The evidence suggests that seigniorage plays at most a modest

role in the persistence of moderate inflations, and that such

inflations can be reduced only at a substantial short-term cost

to growth.

Rudiger Dornbusch Stanley FischerE52—373 E52—373M.I.T. M.I.T.Cambridge, MA 02139 Cambridge, MA 02139and NBER and NBER

September 1991

MODERATE INFLATION

Rudiger Dornbusch and Stanley Fischer1

Much attention has been paid to the process and stabilization of

extreme inflations, at ratea well in excesa of 100 percent per year.2 Much

less attention has been devoted to the inflationary problem in countries

that are stuck with stubborn low double digit inflation, around 20 percent

per annun -- often in the aftermath of stabilization programs that

successfully bring extreme inflations to an end. In the context of European

disinflations in the 1980s, a parallel discussion has focused on how the

European monetary system may have played a central role in allowing

countries like Italy or Ireland to reduce their inflation rates to single

digit levels.

We focus in this paper on the behavior of inflation in countries

that occupy the inflationary middle ground, with persistent annual inflation

rates of 15 to 30 percent. An example, shown in Figure 1, is Colombia,

where inflation has hovered in the 20-30 percent range for more than a

decade. Table 1 shows that the same pattern of persistent inflation in the

20 percent range prevails in Bolivia, Chile, Costa Rica, Egypt, El Salvador,

Ghana, Hungary, Iceland, Israel, Mexico, and South Africa. In each insrance

inflation is too high to be disregarded and to permit a fixed exchange rare.

1The authors are at the Department of Economics, MIT, and ResearchAssociates of the NBER. The research reported here was supported by theWorld gank. We are grateful to Russ Cheetham, Heywood Fleiaig, DannyLeipziger and Liserte Price for providing information, and to Jim Morsink,Tom Skinner and Mursalem Islam for valuable research assistance.2See Bruno eta]. (198B, 1991), and Dornbusch, Srurzenegger and Wolf (1990).

45

40

35

30

25

20

15

10

5

FIGURE 1

COLOMBIA: INFLATION(OPI. 12 months rots)

1971 1973 1975 ¶977 1979 ¶981 1983 ¶985 ¶987 1989 ¶991

But it is evidently also too low to warrant the apparent political and

economic costs of a frontal attack on the problem.

The group of countries shown in Table I includes several - - such as

Bolivia, Chile, Israel and Mexico -- that reached the moderate inflation

range by stabilizing triple digit inflations. Moderate inflation persists

also in countriea that did not reach triple digit inflation, such as Costa

Rica and Iceland. And some countries that did have moderate inflations - -

such as Italy, Spain, Ireland and Korea - - have successfully moved into the

single digit range.

Table 1 Some Recent Moderate Inflations

1986 1987 1988 1989 1990*

Greece 23.0 16.4 13.5 13.7 20.4

Iceland 21.9 17.7 25.6 20.8 15.5

Ghana 24.6 39.8 31.4 25.2

Malawi 14.0 25.2 33.9 12.5

SAfrica 18.6 16.1 12.8 14.7 14.0

Tanzania 32.4 29.9 31.2

Egypt 23.9 19.7 17.7 21.3 7.5

Israel 48.1 19.8 16.3 20.2 18.0

Bolivia 276.3 15.0 16.0 15.0

Chile 19.5 19.9 14.7 17.0 26.0

Colombia 18.9 23.3 28.1 25.8 31.0

Costa Rica 11.8 16.8 20.8 16.9 19.0

El Salvador 31.9 24.9 19.8 17.6 20.8

Mexico 86.2 131.8 114.2 20.0 26.7

Paraguay 31.7 21.8 22.8 26.2

* Last 12 monthsSource: IFS, various issues

For purposes of this paper, we define aoderate inflation as an

inflation that persists for at least three years in the 15-30 percent per

range.3 By requiring rhe inilarion to persisr, we exclude shorter

double digit inflation experiences sssocisted with the supply shocks of the

seventios.

We seok to answer threo bssic questions about moderate inflations.

First, what are the causes of moderate inflation? Second, are these

inflations stable, or does a moderate inflation rate tend to increase unless

definite policies aro put in place to reduce it? And third, what policies

will move a country from the moderate inflation range to single digit

inflation?

We first review some positive thoories of inflation, including

those that focus on seigniorage as well as those that emphasize Phillips

Curve type tradeoffs. From there we proceed to the statistical background,

cataloging the moderate inflation episodes since the mid-l9SOs, and

detailing whether the country moved out of the moderate inflation category

successfully, by reducing inflation, unsuccessfully by moving on to higher

inflation, or sideways by remaining in about tho same inflationary range.

We examine also the stability ptoperties of these inflations.

3Some of the epiaodos in Table 1 therefore do oct qualify as moderateinflations by out definition. Numerical definitions of high, extreme, andhyperinflationa are far from standardized. Dorobusch (1990) defineextreme inflation as more than 6 percent per month, corresponding almostexactly to 100 percent per year. Dornbusch and Fischer (1990) definehyperinflation as more than 1000 percent per year, a rate well below thatimplied in Cagan's classic study (1956), which is close to 13,000 percentper year. One consistent set of definitions is to describe inflation asmoderate in the 15-30 percent range, high in the 30-100 percent range,extreme at 100-1000 percent, sod hyperioflation at more than 1000 percentper annum. We recognire, however, that these descriptions are unlikely togain complete acceptance, both because inflation that is moderate in Boliviais extreme in Switmerland, sod because the number of years needed to achievepersistence can be argued about.

-4-

We then present eight brief case studies of countries that have

experienced aoderate inflation episodes: Brazil, Chile, Colombia, Indonesia,

Ireland, Korea, Mexico, and Spain. Their inflationary experience is

suimsarized in Table 2. In each case we identify the

Table 2 Case Studies

Current Moderate Inflation Former Moderate Inflation

Reached from Reached from Inflation now Inflation now

high inflation low inflation high low

Chile Colombia Brazil Korea

Mexico Indonesia

Ireland

Spain

circumstances through which the country reached the moderate inflation

range, and how long it stayed there. We describe the mechanisms of

instability when inflation is in the moderate range. We are particularly

interested in the four countries that successfully disinflated from the

moderate range. So far as we are aware, Indonesia is the only country that

in the period since 1960 has suffered sustained extreme inflation (more than

100 percent) and then stabilized to the single digit range.4 Of course, the

classic hyperinflation countries achieved rhsr fear earlier.

41r is for this reason that we include a case study of Indonesia eventhough, as we shall see below, it does not meet the strict criterion forhaving experienced a moderate inflation episode. Korea experienced extremeinflation at the end of World War II and during the Korean War, andtherefore is similar to Indonesia in now being a low inflation country,having experienced extreme and moderate inflation.

In the case studies, we pursue the fsctors that determined the

choice between allowing the iuflation to continue versus disinflsting. We

detail the implementation of disinflation policies in those countries thst

succeeded in stabilizing, examining the exchange rate commitment, the use of

incomes policy, and trade liberalization, as well as monetsry snd fiscsl

policies. We also discuss the costs of stabilization.

In Section IV we draw on the case studies to summarize some lessons

of disinflstion from moderate inflation, as well ss the lessons from the

other cases where countries have not yet disinflsted or else moved on to

higher inflation.

I. WHY IS THERE IHFLATION?

There are basically two answers to the question, why is there

inflation? One is that inflation is an integral part of m country's public

finance. The other is that inflation continues because it is too hard or

too costly to stop it.

1. Inflation and Public Finance

At least since the l920s it has been understood that money creation

is one way, albeit not the preferred one, of financing budget deficits. In

his classic article, Keynes (1923, Chapter 2) in commenting on the

hyperinflation experiences of Germany and Russia clearly pointed out that

even the weakest government always has one way left to pay its bills, namely

printing money.

It might be thought that the seigniorage argument is only relevant

to extreme high inflation economies, but of course that is not the case. As

Table 3 shows, inflationary money creation accounts for a significant

portion of government revenue even in economies with moderste rates of

inflation. It is therefore not implausible to consider inflation as a

conscious part of public finance.5

Table 3 Inflation and Seigniorage

Inflation Seigniorage5 seigniorageigevb

ColombiaC 23.4 2.5 17.6

creeced 19.7 2.6 11.2

Portugal4 19.3 3.5 6.5

Chilee 22.8 0.4

tmchange in highpowered money as a percent of CDP.

bseignjorage as a percent of government revenue including seignioraga.c197685 l98287 e 1982-89

Source: IFS

What predictions can we get from the seigniorage argument? In his

classic work, Cagan (1956) introduced the norion of a revenue-maximizing

rate of inflation, and also showed that most countries were inflating at

well beyond those rates in the hyperinflarions. Friedman (1971) went

further and noted the role of real income growth as a source of seigniorage

revenue. The revenue from money creation can be written as the sum of rwo

terms, the first arising from inflationary money creation, the second from

growth-induced increases in money deoand:

S/P (it + (n +

where it is the rate of inflation, n the growth rate of population, r the

income elasticity of real money demand, and g the growth tate of real

incooe. Friedman focused on the tradeoff between the seigniorage revenue

5See, for example, Phelps (1972) and Fischer (1982) on optimal inflation ina theory of public finance.

from inflationary money creation (am) and rhe revenuea that accrue from

money creation linked to economic growth ((n + g)m). With higher ratea of

inflation real balances are lower and hence the growth benefita apply to a

smaller baae.

Suppose the demand for real balances takes the Cagan form L —

Nf(y)e7T, then the revenue maximizing rate of inflation ir* is given by

(2) — 1/b - (n+vjg)

where the term (n+vg) is the Friedman modification. However, the

modification leads at high inflation rates to relatively little change in

the revenue maximizing inflation rate. Cagan (1956) estimates b (denoted a

in his paper) to be about 6 months, or 0.5 years. With b — 0.5, the peak of

the seigniorage Laffer curve would be reached at 200 percent per annum.

Assuming that q is unity, the revenue maximizing inflation rate would be

190%, even for a real growth rate as high as 10 percent per annum. The

illustrative calculations in Table 4 show how sensitive the revenue

maximizing inflation rate is to the estimate of b, and how relatively

insensitive it is to the Friedman correction.

Table 4 Maximal Seigniorage in the Friedman Approach

(Percent inflation per year)

Value of b0.25 0.5 1 5

Growth rare, g:0.00 398 198 98 18

0.03 393.5. 193.5 93.5 13.50.06 389 189 89 9

Note: Calculations using equation (2) with n=.02 and p—li.

Bailey (1956) was the first to study the optimal inflation tax

rare, which is of course below the revenue maximizing rare. He focused on

the welfare cost of reduced real balances, noting that the welfare cost

increases with the square of the inflation rate. Hence extremely high

inflation rates would be ones facie inefficient. Bailey concluded from

this line of argument that inflation rates in excess of 10 percent per year

would be implausible in an optimal design of government finance.

The optimal inflation rate is calculated by equating the marginal

social cost of raising government revenue through inflation with the

marginal social cost of alternative sources of revenue. Bailey's

calculations, which do not take account of gtowth, imply that

(3) ,r** —

where ,c** is the optimal-tax inflation rate, and (l+p) is the marginal

social cost of raising an extra dollar in tax revenue. Table 5 shows

optimal-tax inflation rates calculated from (6

Table S Optimal Inflation Rates in the Bailey Approach

(Percent inflation per year)

Value of b0.25 0.5 1

Value of p0.1 36.4 18.2 9.1

0.2 66.7 33.3 16.7

0.5 133.3 6.6 33.3

Note: Calculations using equation (3)

6We have made two special assumptions in deriving (3) . First, assuming themoney demand function is (NIP) — y em, we have assumed (-yy)-l; thisassumption does not affect the result. Second, we have assumed the optimalinflation rate is zero rathet negative. With (-ir*) as the optimal inflationtate, the full exptession fot the tax-optimal inflation rate is given by

(3)' ir** — [p/(l+p)b] - lr*.

The Bailey analysis appears to put tax-optimal inflation rates in

the moderete inflation range.7 We tannot be more categorical without better

estimates of the functional fotm of the high-poweted money demand function,

its elasticity, and its stability ptoperties. In addition, taking account

of the non-menu costs of inflation would teduce the optimal inflation rate.

The non-menu costs of inflation, and the gradual shift away from

money holding that is common in moderate inflation as well as high inflation

economies, make us sceptical of the public finance argument for moderate

inflation. However, we do accept the implication of the Bailey analysis

that inflation rates will be higher in countries where alternative sources

of revenue are costly. Bailey's results thus help account for generally

higher inflation rates in Latin American countries, which have great

difficulty raising normal tax revenues.

Game-Theoretic Complications

The central point of the simplest game-theoretic equilibrium models

is that the public adjusts to any credible change in policy; thus

disinflation is in principle no problem. But announcements of disinflation

are not credible if the government has a separate agenda from the public.

Specifically, if the government has an incentive to mislead the public then

the public must anticipate this possibility and the only viable equilibrium

is one where rhe marginal incentive to cheat is balanced by the marginal

cost of doing so. This is typically a "bad' equilibrium for horh the

government and the private sector relative to equilibria that would be

attainable if opportunistic government behavior could be ruled out.

7Bailey obtained a low ram-optimal rate of inflation because he assumed avery low collection cosr, of only 7 percent of revenues, and also had a highb (0.75).

- 10

Barro (1983) and Bruno (1991) have placed the seigniorage argument

in a game-theoretic context using the Barro-Cordon approach to the problem

of precomuiitment.8 Consider a policy maker who minimizes an objective

function that has both the inflation rate and seigniorage as arguments:

(4) V — wL(w*) - 72/2

The policy maker optimizes conditional on the rate of expected

inflation, w*. But the equilibrium under rational expectations requires

that the public's expectations recognize the temptation to inflate, so that

in equilibrium, The equilibrium inflation rate in a situation without

precommitment is therefore given by:

(5) w — L(m)/-y

Figure 2 shows the conventional seigniorage-Laffer curve OL for a

Cagan demand function with maximum revenue at point A and the corresponding

inflation rate of w0. Bruno (1991) shows that equilibrium inflation in this

game may exceed the maximum revenue rate of inflation. Two competing

considerations enter. While the marginal collection cost, 71r, works to

dampen the equilibrium inflation, the absence of precomzeitment - - which

requires that in equilibrium inflation be such that there is no temptation

to surprise money holders - - tends to raise the inflation rate.

If the only social cost of inflation were the area under the demand

curve, then the game theoretic analysis would imply a higher inflation rate

than the optimal tax analysis. The possibility exists that this expanded

model of seigniorage supports the notion of equilibrium inflation rates in

the 15-30 percent range, but it would be difficult to calculate the

equilibrium inflation rate that emerges from an analysis of this type.

8See, too, Kiguel and Liviatan (1990).

Figure 2

Seigniorage and Inflation

Canes

tc

A

Cost

0 Seigniorage

- 11 -

Implications for Stabilization

The seigniorage argument - - whether in the optimal tax, or in the

game mode -- aakes inflation plausible because, within a given tax

structure, inflation is a relatively low-cost way of raising revenue. But

clearly that is only true within a given structure.

If the marginal cost of raising government revenue can be lowered

through tax reform, then optimal inflation too will be reduced. In this

perspective tax reform would be an essential measure to accompnay and

support inflation stabilization.

2. Inflation and Unemployment

The main alternative game-theoretic model of inflation also focuses

on the lack of precommitment, but the cornerstone of the game is

unemployment rather than seigniorage. Once again, wages and prices are

assumed fully flexible and there would be no problem in shifting to a

noninflationary equilibrium if only the government could credibly commit

itself. Once again, the government has a separate agenda that introduces

the temptation to cheat and surprise.

In this model due to Barro and Gordon (1983) the government

minimizes a loss function in which the deviation of unemployment from the

government's desired unemployment rare, ku*, and inflation are the

arguments. Because of distortions, for example in the tax structure, or of

taste differences, the government's target rate of unemployment is only a

fraction k of the natural rate at which the labor market clears and that

governs inflation dynamics.

(6) V — (u-ku*)2 + 052; 0 < k c 1

- 12 -

In the labor oarket, inflation depends on inflationary expectations

and on the discrepancy between the actual and natural rates of unemployment:

(7) IV = - $(u-u*)

The government maximizes (i) subject to the inflation equation, taking the

inflationary expectation as given. In equilibrium the solution must satisfy

m=m*. Equilibrium inflation therefore is:

(8) it — (l-k)u*/afl

Inflation in this model is strictly the result of a lack of

precommirmenr. Equilibrium inflation does not come as a surprise and as a

result it fails to reduce unemployment below the natural rate. The

equilibrium level of inflation is higher the higher the wedge between the

social and private natural rate of unemployment, the more the government is

concerned with the employment objective rather than with inflation, and the

smaller the impact of unemployment on inflation.

Depending on how smbitious and hew stupid the government is, this

model could support the idea of steady inflation at 20 or 30 percent.

However the parameters that appear in (8) have not been estimated in a way

that makes it possible to narrow down the implied range of inflation.

The general spirit of this modal can be taken in several

directions. One possibility is that the public does not know the

characteristics of the policy maker. In this case learning and reputation

building come into play.9 Taking account of reputation generally reduces

the equilibrium inflation rate below that implied by equation (8) , but also

suggests -- realistically -- that inflation rates are likely to be lower in

9See Andersen (1989), Perason (1988) Persaon and Tabellini (1989), Driffill(1989), Blackburn and Christensen (1989).

- 13 -

countries with more stable governments where policymakers and the

institutions in which they operate have the oppottunity to establish

reputations.

The central place of precommitment and reputation in game theoretic

models supports the notion embodied in the creation of independent central

banks that institutions and policy makers should be designed to reduce the

incentives for opportunistic behavior and ambiguity about preferences. For

example, appointing conservatives to run the central bank would lead to

lower inflation. So would pomitive disincentives for policy makers to

create inflation.

3. Inflation Too Costly to Stop

A different motive for inflation comes from the observation, or at

least the belief, that inflation is costly to srop. One might call this the

"Brookings School" view. Once a commonplacej0 it came under attack in the

l980s, notably by Sargent (1982, 1986), who brought evidence from the end of

hyperinflations, and from the UK and France in the l920s to shift the focus

of attention to the credibility issue and away from the notion of price

stickiness that did not result from slow adjustment of expectations.

The typical persistence model, spelled out in some derail, is given

in the following equations where w denotes wage inflation and e the rate of

depreciation of the exchange rate. The disturbance term is expressly

recognized since supply shocks play an important role in the inflation

105ee, for example, Tobin (1980) discussing the prospects for disinflationin the 1980s.

- 14 -

process.

(9) iv — aw + (l-a)e 4- 0 < a C 1

(10) w — - Au

(11) e — flit + (1-fl),r1 0 C fi C 1

(12) iv — it1 + 9 - aA8u 0— l/[l-fl(l-o)]

(13) u — u1 - 7(m-m) - (e-w)The model includes cost-based pricing (equation (9)), a wage

setting equation (10) and an exchange rate rule (11). These three

equations imply an accelerationist Phillips curve (equation (12)); the model

is completed by an aggregate demand equation with real money growth and real

depteciation as the driving forces (equation (13)).

The model assumes persistence because lagged inflation appears

mechanically as a determinant of current wage and price inflation. In such

a model disinflation is costly because inflation csn be lowered only via a

protracted period of unemployment.

Indexation

In economies where inflation is substantial - - say 20 percent per

year -- some implicit or explicit form of indexation is unavoidable. tn many

countries wage increases follow a regular pattern of once or twice a year

adjustments, often mechanically based on past inflation. This is, of

course, an extreme form of inertia: wage inflation is given by past price

inflation. The higher is past price inflation, the more work that has to be

done by unemployment in bringing down wage inflation. This point is quite

obvious from equation (10) above.

However, some care has to be taken in discussing the relationship

between indexation and inertia. As can be seen in Taylor (1982) or Fischer

15 -

(1986), indexation can spead up the rasponsa of prices to a reduction in

money growth. The comparison that is being made in these papera is between

indexed wages and wages that are predetermined; the response is more rapid

with indexed wages because they adjust sooner to any initial reduction in

inflation achieved by policy.

Indexation is associated with inertia, especially in the Latin

American context, for at least two reasons. First, indexation leads to

longer contracts than would exist in its absence. With high and unstable

inflation rates, labor contracts would be very short if they could not

compensate for inflation that was unanticipated at the time the contracts

were made. But since longer contracts generally increase inertia, wage

indexation tends in these circumstances to increase inflationary inertia.

Second, the typical indexing formula used in practice tends to make the real

wage a negative function of the inflation rate This means that the real

wage rises when the inflation rate is reduced, implying higher

unemployment. 1.2

If wages are set by a formula depending mainly on the past behavior

of inflation, there will be very little scope to enlist forward looking

expectations effects. In a chronic inflation situation either a suspension

of indexation or else protracted high unemployrienr will be inevitable in the

process of stabilization. We return to the question of indaxarion in

discussing incomes policy.

11This relationship has been examined by Modigliani and Padoa-Schioppal978) and Simonsen (1986); see Fischer (1988), equation (20)20f course, the short run impact of higher real wages also works throughthe demand side and on that account may well raise output, notably in thencntraded goods sector. This theme is familiar from the literature onconrracribnary devaluation.

- 16 -

Combining Inertia and Exoectations

The above model neglects explicit expectations. Fischer (1977,

1986) and Taylor (1980, 1982) offered models that strike a balance between

the fully flexible price models in which inflation is exclusively determined

in a forward looking fashion and the fact of overlapping, long term

contracts that introduce an eleaent of inertia.'3 In these rational

expectations models inflation is still linked to the past because existing

wage settlements include expectations based on past information. But the

more forward looking is pricing, and the shorter are contracts, the less

recessionary a disinflation will be - provided of course that the change in

policy affects expectations of future prices and wages.

With full credibility, policies that stabilize inflation without

creating unemployment can in principle be designed in these models)-4

However, non-recessionary disinflation takes very long -. in Taylor (1982),

it requires 5 years to disinflate fully, even with full credibility for the

policymakers. The job can be done faster if unemployment is allowed, but of

course the assumption of full credibility will in practice not be satisfied

and that may raise the unemployment cost very substantially.15

135ee, too, Fellner et al (1981).141n Fischer (1986), a stabilization program announced as far ahead as the

longest contract in the economy can be implemented costlessly; Taylor (1982)presents numerical solutions for such programs.5Ca1vo (l983a,l983b) has proposed a model of forward looking price settingin which one can investigate the effect of a change in the monetary growthtate. A change in money growth immediately change the rate of inflation,though not the j&ygj. of prices. Fuhrer snd Moore (1990) note that Calvo'smodel cannot account for sticky inflation and offer an ad hoc adaptation.Ball (1990, 1991) addresses the same issue and recognizes that in a Taylorsetting the level, not the rate of change, of prices has inertia. Heconcludes that disinflation ought to lead to a boom -. as the lower

expectation of future prices leads through the Taylor wage- and price-setting assumptions to a reduction in the current price level and thushigher real balances. The standard result is that the start of a credible

disinflation should be accompanied by a step flc.te in the money supply,to provide for the incressed real balances demanded as a result of lowerexpected inflation. This mechanism is not present in the Ball model.

- 17 -

Innovations in Credibility Manamement.

Recent policy experiments have focused on enhancing credibility

along with actual monetary disinflation. In Chile, for example, the Central

Bank was formally made independent of the government in 1989. In New

Zealand an elaborate agreement between the Treasury and the Central Bank in

1989 obliged the latter to achieve a stable price level by the end of 1992.

Part of that agreement ties the remuneration of the Governor of the Central

Bank to success in disinflation.16 The rate of inflation in calendar year

1990 was to be brought down to 3.5 percent, in 1991 it was to be in the 1.5

to 3.5 percent range; the inflation rate is supposed to be 0-2 percent in

1992. In the 3rd quarter of 1990 the 4 quarter inflation rate was still 5

percent, down from 1989 and falling, but above target. The economy was

already in a serious recession.

Canada recently announced an agreement between the Minister of

Finance and the Governor of the Bank of Canada to bring inflation down from

5 percent in 1990 to 3 percent by the end of 1992. A further reduction to 2

percent is to be accomplished by 1995. Although the Canadian package is far

less ambitious than that of New Zealand, it too attempts to lower the cost

of disinflation by directly influencing expectations.17

Summary

Even when there is some room for expectations to influence the

current setting of wages and prices, the overhang of existing contracts

prevents costless disinflation. The costs of disinflating would be higher

16See Reserve Bank of New Zealand.17See Press Release dated February 26, 1991 of the Bank of Canada, Selody(1990) and Lipsey (1990) for the case of Canada.

- 18 -

the longer the avetage duration of existing contracts. At inflation rates

of 15-30 percent, contracts tend to have a one year duration and hence near-

instant disinflation is impossible without a sharp rise in unemployment.

Wage-price inertia models with rational expectations inevitably

lead to an emphasis on the role of expectations and the hope that

institutional changes can decisively stop inflation nearly costlessly. No

doubt institutional changes can play a powerful role in cementing in a

reduction in inflation, gut the evidence from New Zealand and Chile

suggests that such changes are unlikely to work immediate magic under

conditions of moderate inflation.

The disinflating policymaker has to deal with two elements central

to different models -- seigniorage, and the mechanics of wage-price

dynamics. Significant amounts of seigniorage, 2-3 percent of ON?, are

typically being collected in moderate inflation countries, and inflation

will not stop unless the government deals with the fiscal problem by cutting

expenditures or raising taxes.

Second, inflationary inertia, whether resulting from the slow

adjustment of expectations or from the presence of contracts, has to be

taken into account. A convenient starting point is to go back to (9)

repeared here for convenience in a slightly different form, adding and

subtracting lagged inflation on the right hand side:

(9a) — + o(w-ir i + (l-o)(e-m1) +

The equation underlines the persistence of inflation. Inflation

today will be equal to inflation yesterday except for any combination of the

following:

- 19 -

• Wage inflation falls below past price inflation. This requires a

break with any implicit or explicit backward locking indexation. The

suspension of indexation, or introduction of an incomes policy could

accomplish this.

• Exchange depreciation falls below the rate of past inflation.

• Favorable supply shocka lead to disinflation without the need for

the exchange rate or wages to take the lead.

The basic point is thst the inflation process tends to perpetuate

itself even after a government has changed the policies that sustain the

ongoing inflation. For inflation to fall, there has to be a major break in

the process whereby each sector, including the monetary authorities,

accommodates the inflation rate of every other sector. One possibility is a

change in the structure of indexation among wages, prices and the exchange

rate. Another is a change in the rules for setting the exchange rate and

for public sector prices. Use of the exchange rate to initiate a

disinflation is very common, but it risks leading to a situation of

overvaluation which then greatly complicates the unwinding phase.18 Or else

it might be a change in the wage rules that move from compensating for past

erosion of the purchasing power of wages to a forward setting based on

18folicies that attempt to reduce inflation by stabilizing the nominalexchange rate or other government controlled prices run enormous risks ofunsusrainability if inflation fails to respond. Thus there can be no way ofpursuing these policies to the bitter end; they have at some stage to beabandoned if they fail to reduce inflation. All such policies have to belabelled toxic if taken to excess. The successful governments are thosethat know when and how to stop trying to use this particular medicine.

- 20 -

expected inflation.'9 But if all else fails high unemployment will have to

be used to slow inflation by reducing wage and deaand pressures.

In the case studies below we will highlight how the problem of

cutting into the inflationary process was addressed each instance.

II. STATISTICAL OVERVIEW

There is need for a working definition of moderate inflation. The

rate has to be high and persistent enough to set it apart from the problems

of the U.E. or the U.S., yet low enough to put it in a category clearly

distinct from high, extreme or hyperinflation. We define a moderate

inflation episode as one in which the annual inflation rate is in the 15-30

percent range for at least three years.

The emphasis on the inflation being sustained is essential to set

the experiences apart from supply shock inflation. The upper limit of the

range is not very important, whether to end at 25 or 30 percent, but the

lower limit does affect the number and length of episodes. The duration is

more significant; there would be many oore episodes if we used a two year

duration and far fewer if we used a four year duration - - as can be seen in

Table 7 below, which presents a list of the episodes of moderate inflation

in the period since 1950, as well as in Table B which lists moderate

inflation episodes by their duration.20

19If the stabilization program is indeed accompanied by a fundamental changein fiscal policy, then inertia can be reduced by a one-time suspension ofindexation rules - - for example that workers and asset-holders forgo oneinflation adjustsent. Provided the new policies are consistent with lowinflation, indexation can later be restored if that has to be done.20Data are very incomplete for the 1950s and the weight of the experiencetherefore comes from the post-1960 period.

- 21 -

Table 7 Episodes of Persistent Moderate Inflation(15-30 percent for at least 3 consecutive years)

Country Period Period Average InflationIn Period 3 Years 3 Years

Before After

New Zealand 1975-77 15.3 8.7 14.31980-82 16.2 13.3 9.7

Finland 1974-76 16.3 8.2 9.3Greece 1979-87 20.7 12.7 15.6Iceland 1986-89 21.6 48.4 naIreland 1974-76 18.6 9.7 11.5

1980-82 18.6 11.4 8.2

Italy 1974-77 17.8 7.1 16.01980-82 18.5 14.7 11.6

Poland 1983-86 17.5 43.8 112.1

Portugal 1974-85 22.7 8.9 10.2

Spain 1974-80 17.6 9.3 13.7

Turkey 1955-59 18.0 11.9 1.61973-77 19.0 11.4 71.4

Yugoslavia 1971-75 19.3 7.9 13.11977-79 16.5 18.9 34.1

UK 1974-77 18.1 8.6 13.2

Ethiopia 1977-79 15.7 14.6 5,5*Liberia 1973-75 17.5 1.8 6.4*

Seychelles 1972-75 20.6 ns 13.9Sierra Leone 1974-76 17.2 3.3 13.5*Somalia 1974-76 17.3 1.0 15.0*South Africa 1985-87 17.0 12.8 13.9Sudan 1973-75 21.8 6.3 12.7

1979-81 25.2 22,5 36.7Swaziland 1979-81 18.3 11.0 12.0Zaire 1972-74 20.3

' 6.7 66.0Zambia 1976-78 18.3 8.2 11.4

Korea 1974-76 21.5 9.5 14.31979-81 27.8 13.3 4.3

Pakistan 1973-75 23.6 5.1 7.8Western Samoa 1981-83 18.4 15.4 9.4

Bahrain 1973-78 18.5 4.2 5.8

Egypt 1982-84 16.0 13,6 18.61986-90 20.5 15.0 na

Iran 1980-83 20.8 16.5 11.8Israel 1987-90 18.3 224.2 na

Syria 1980-82 17.3 7.1 10.9*

- 22 -

Bolivia 1987-90 15.3 4435.8 naBrazil 1968-72 20.7 45.9 231Chile 1965-68 24.3 oa 27.6

1986-89 17.8 26.0 na*Colombia 1973-76 22.1 9.7 25.2

1978-89 23.1 25,4 usCosta Rica 1987-90 18.3 13.0 naEl Salvador 1979-81 15.6 10.7 12.2

1987-89 20.8 21.9 25.5Crenada 1977-81 19.6 na 6.5

Guyana 1978-83 17.5 8.4 16.0Haiti 1973-75 18.2 4.7 3.6Hexico 1974-76 18.3 7.4 21.6

Paraguay 1955-57 20.4 69.7 8.1Trinidad &Tobago 1973-75 17,9 5.1 10.9

1979-81 15.5 10.9 13.4

Uruguay 1969-71 20,4 96.0 83.6

* These episodes include year(s) in which the inflation rate is between 14and 15 percent.Source: IFS, various issues

The table includes 55 episodes, drawn from the behavior of

inflation in 131 countries. Just over half these episodes, 28 of them,

started during the oil price shocks and lasted no more than four years.

Clearly many of the moderate inflation episodes were triggered by commodity

price shocks. The table leads us to raise a number of questions:

• Is there a high incidence of repeat offenders? The answer is

clearly no.

• llhere do countries that find themselves in moderate inflation

spells come from and where do they go? Host countries come from low

inflation. Leaving moderate inflation they typically stay on average in the

neighborhood of moderate inflation, or go back to a lower inflation rate.

Very few transit to higher inflation. Of the episodes in Table 7 for which

post-episode information is available, 25 had average inflation below 15

percent for the next three years, 18 had inflation that averaged between 15

and 30 percent, and only 6 had inflation that averaged more than 30 percent.

- 23 -

Table 8 summarizes the persistence of moderate inflation episodes.

The table shows the number of spells of a given duration in Table 721

Thus, for example mote than half the moderate inflation spells last only

three years. The evidence thus shows that most countries that enter the

moderate inflation zone do not stay thete very long.

Table 8 Spells of 15-30 Percent Inflation

Yeara of consecutive moderate inflation3 4 5 6 7 8 9 . . 12

No. of

spells 31 12 6 2 1 0 1 2

Percent 56.4 21.8 10.9 3.6 1.8 0 1.8 3.6

• For most countries moderate inflation is a transitory experience.

There ate very few countries where moderate inflation becomes a way of life:

there are only six spells where inflation is in the 15-30 percent range for

mote than five years. The two longest spells are those of Portugal and

Colombia, each lasting twelve years (and Colombia still continues).

21Some of the spells in Table 7 were not completed. All spells shown inTable 7 as ending in 1988 or earlier were completed; some of those shown asending in 1989 may not have been completed (data for 1990 were not availablefor all countries); spells shown as ending in 1990 may be continuing.

- 24 -

III. CASE STUDIES

In this section we offer several case studies, tepresenting

different transitions into or out of moderate inflation, as shown in Table

2. We statt with the countriea that are currently experiencing moderate

inflation after stabilizing a high inflation - - Chile and Mexico

respectively. Other countries in this situation are Israel and Bolivia. We

then examine the case of Colombia, which, having reached moderate inflation

from low inflation, is the longest-lasting moderate inflation country. We

turn next to Brazil, which stabilized a high inflation successfully and

reached moderate inflation in 1968, but then failed to stay in this region

and returned to high inflation. We conclude with four countries that have

successfully reduced moderate inflations and now experience low inflation,

Korea, Indonesia, Ireland, and Spain.

Chile

Chile is today seen as fig example of successful macroeconomic

stabilization and structural adjustment. There is no question about the

success, but there should also be no illusion about the cost at which these

accomplishments were attained - - violent political repression for almost two

decades, and mass unemployment until very recently.

Table 9 reviews key Chilean variables in the l980s and Figure 3

shows the path of inflation.

60

50

40

30

20

10

197

FIGURE 3

CHILE: INFLATION IN THE 1980s(12 onths Rat.)

1990 1982 1984 1986 1988 1990 1992

- 25 -

Table 9 Chilean Macroeconomic Variablea in the l980s

Budget Real in Unemp. Real Real exch. Infi- Seignior-def.a rate (%)b rateC waged rated ation agee

1980 5.5 12.2 14.5 88 95 35.1 2.41981 2.4 28.8 13.7 103 108 19.7 -0.71982 -2.2 35.1 27.2 103 97 9.9 -1.71983 -2.6 15.9 36.5 92 89 27.3 0.81984 -2.9 11.4 28.3 92 90 19.9 0.91985 -2.3 11.1 23.9 88 80 30.7 0.81986 -0.0 7.7 18.9 90 89 19.51987 0.5 9.4 16.2 89 66 19.91988 -0.3 9.9 12.0 95 61 14.71989 62 17.0

apercent of CDP, general government bRealized active rate cparticipants ingovernment work program included among unemployed dlndex 1980-82-400eohange in money base as percent of COP.Sources: IMF Covernment Financial Statistics, IFS, CIEPI.AN "EstadisticasEconomicas" various issues, and Morgan Cuaranty.

The 1970s Miracle. Following the military coup in September 1973, the

Pinochet government rapidly established fiscal austerity and tight monetary

control. "Chicago monetarism" was the rule. From the shambles left in the

aftermath of Allende's populism the economy was rebuilt to become by 1990

the showcase of what a developing economy cught to look like.22 But

disinflation was slow even though unemployment increased sharply. The

reason was primarily automatic wage increases resulting from full backward-

looking indexation provided for by law.

After the intial orthodox stabilization, the next step was an

attempt to disinflate by using the exchange rate as a nominal anchor.

Recognizing the cycle of inflation, exchange rate depreciation, and wage

increases, to be followed by the next round of inflation, the government

22See Edwards and Edwards (1987), Ramos (1986) and Foxley (1983). Corbo andSolimano (1991) oiier an excellent perspective on the entire experience

- 26 -

first implemented a preannounced tablira of exchange rate depreciation, and

then fixed the exchange rate in 1979, despite an inflation of 30 percent.

But as eqs. (9)-(ll) show, with backward looking indexation, a fixed

exchange rate will lead to teal appreciation and consequently unemployment.

The fixed rate was maintained until 1982, resulting in growing real

exchange rate apptecietion and contributing to Chile's subsequent debt

crisis. Over time, however, the fixed exchange rate combined with a budget

surplus and tight money played its role: inflation started coming down.

But, because of backward-linked indexaticn of wages the decline in inflation

was slow and real wagea started rising.23 In the short run the gain in real

wages sustained real aggregate demand and even gave the 1970s miracle a

terminal boost. But by 1982 the overvaluation in conjunction with massive

external shocks made an exchange rate collapse certain. The actual

abandonment of fixed rates (amidst the debt crisis of 1982) was followed by

major exchange depreciation and the prospect of renewed inflation.

The 1980s. Following the collapse of the fixed rate regime, very tight

monetary policy and a cyclically adjusted budget surplus forced a deep

depression of economic activity. Real CNP declined by 14 percent in 1982,

and by another 1 percent in 1983.

Unemployment, including a government work program that paid a

fraction of market wages soon accounted for more than 30 percent of the

labor force. In the subsequent years recovery gradually brought down the

record unemployment, but until the late l98Os unemployment was high enough

to keep a firm lid on wage increases and hence on inflation. Even with the

238ee Edwards and Edwards (1987) Corbo (1985) on the interaction betweendisinflation and real wage gains.

- 27 -

collapse of the exchange rate and the significant real depreciation between

1981 and 1988, inflation never went hack to the high levels of the 1970s,

but rather settled in the 15-25 percent range.

Unemployment was certainly not the only factor in maintaining

inflation stability. Increasingly the government succeeded in establishing

a consensus around economic policy. It came to be believed, mote so after

unemployment had come down from peak levels, that a demand-driven program of

recovery could result in renewed inflation and chaos. That view was

increasingly reinforced by the unhappy inflationary experience in other

Latin American countries, notably Peru, Argentina and Brazil.

The relative stability of inflation seems puzzling to those who

would expect the massive unemployment to exert far more of a disinflation

effect. This puzzle helps solve the other puzzle, of why as large a real

depreciation as occurred in 1984-86, and continuing moderate real

depreciation afterwards, did not translate into an acceleration of

inflation. Unemployment and teal depreciation largely offset each other

with the inflation rate remaining broadly unchanged. The government "de-

indexed" the economy in 1982, abolishing the formal and legal obligation to

pay wage increases of at least the past rate of inflation.24 But, de facto,

backward looking indexation continued to be largely practiced in the private

sector. Falling oil prices after 1984 helped cushion the exchange rate

depreciation's inflationary impact.

Seigniorame: Table 9 shows that government revenue from the printing of

money was quantitatively unimportant in the 1980s. Seigniotage was mote

24See Cotbo and Solimano (1991).

- 28 -

important in earlier periods, in particular amounting to 17 percenr of GOP

in 1973, and remaining close to 5 percent of GDP through 197g. The fiscal

disorder under Allende thus led to inflation via money printing, and rhe

need for seigniorage could for some time have continued to be a factor

supporting the continuation of inflation. But there is no reason to think

that the need for seigniorage played any significant role in the maintenance

of moderate inflation in Chile after 1982, especially given the massive

fiscal effort that was undertaken during that period.

The 1990 Transition: Chile's success in institutionalizing conservative

polities is most apparent in the transition to a democratic government in

1990. This wam a natural time to fear that the opposition government, more

open to the concerns of labor and the left, might quickly give in to

pressures for spending and expansion. The risk posed by such policies was

all the more real in that Chile had by 1989-90 been taken to the threshold

of full employment. The transition was then an obvious point at which

expectations of inflation and institutional instability might return and

lead to an escalation of inflation.

This did indeed happen, though perhaps more as a result of

Pinochet's overheating the economy at the very end than as a result of fears

of immediate mismanagement of the democratic government. But against a

background of an acceleration of inflation the incoming government took a

firm stand: in the campaign they assertively endorsed highly conservative

econosic management. Once in office they actually practiced it. 1990 was a

year of slower growth, necessary to cool off the economy and set the srage

for sustained and stable growth in the years to come, Inflation did rise in

the calendar year to 27 percent. But by December the growth-recession had

- 29 -

done its work and inflation rates had been pushed down sharply. The point

had been made that inflation at 20-25 percent was acceptable, but open-ended

inflation was not.

The transition was marked by an important institutional innovation.

An independent Central Bank was established whose organic law established

its responsibility to assure monetary stability and the normal functioning

of the payments mechanism. Ctowth or full employment were not made parr of

its task description. The creation of an independent central bank is widely

viewed in Latin America today as jjg key step in stopping inflation - - in

Chile it was more the final step in assuring that a disinflation process was

locked in.

It is important to recognize that Chile today, and throughout the

l9BOs, never achieved inflation in the single digit range except just before

the 19B2-3 depression. Even today the government is not undertaking

policies that would attain single digit inflation in the foreseeable future.

Inflation in the 20 percent range appears to be accepted and the chief focus

of attention is to avoid its acceleration, if necessary with an unpopular

slowdown. Figure 3 shows a decade of inflation in the 20 percent range.

Clearly it is possible to stay in this range for a long time. But the

experience of 1990 marks just how essential it is, at a key political

juncture or in an external crisis, to establish firmly the determination to

avoid acceleration.

Today in Chile there appears to be a political economy equilibrium

with broad support. It involves the recognition that inflation acceleration

must be resisted because it would ultimately impose a large cost in terms of

political and economic instability. But the equilibrium appears also to

- 30 -

include the tecognition that tapid disinflation to a level below 10 percent,

say, would involve unemployment at levels that are not worth the price.

Mexico

Mexico, like many other countries, entered the moderate inflation

range during the first oil shock, in 1974. It stayed in that range through

1981, having had to move to a floating exchange rate in 1976. Despite its

booming oil exports, Mexico ran large balance of payments and budget

deficits at the end of the seventies and the beginning of the eighties,

using real exchange rate appreciation to help keep the lid on inflation.

In the 1980s Mexico fell apart. Gross mismanagement in the public

sector in the early 1980s, exchange overvaluation and excess indebtedness

caused a collapse in 1982. The rest of the decade was devoted to rebuilding

the country. Real wages fell dramatically as real depreciation was required

to finance debt service and capital flight. Growth disappeared. Inflation

exploded on two occasions, in 1983, in the aftermath of a typical election

year, and again in 1987-88. (See Figure 4)

The reconstruction of financial stability starred in the

administration of Miguel de La. Madrid (1982-88). Noninterest budget

surpluses were built up (Table 10) to finance domestic and external debt

service in a noninflationary fashion. But inflation control remained the

biggest challenge. The lessons of Argentina, Brazil, Israel and Peru were

closely studied and conclusions drawrt: incomes policy and price freezes

worked for a while in Argentina, Brazil and Peru, but succeeded in the

longer term only with fiscal consolidation, as in Israel. The right lesson

was drawn: that disinflation vithout fiscal discipline was unsustainable.

150

140

130

120

110

100

90

80

70

60

50

40

30

20

10

FIGURE 4

MEXICO: INFLATION IN THE 1980s(12 lonth, Rat.)

1980 1981 1982 1983 1684 1985 1988 197 1988 1989 1990 1991 1992

- 31 -

But a positive lesson was drawn too, namely that disinflation without

intomes policy, relying solely on tight money and tight budgets, would be

unnecessarily expensive.

Table 10 Mexico's Stabilization

1985-87 1988 1989 1990

Growth 0.2 1.3 3.1 3.9Inflation 94 159 20 29

Primary budget surplus 3.2 8.1 8.3 7.5Real interest rate 3,3m 34 20.3 12.5Real exchange rateb 73 77 74 70

Seigniorage 2.8 1.6 0.4 1.2

i98687 blndex 1980-82—100 cShate of GOPSource: IFS, Morgan Guaranty and Hacienda, Mexico

The Mexican disinflation program -- the £4.l.Q -- was initiated in

December 1988 and is still underway. The gç.ga is a tripartite agreement

among the government, unions, and business. The public sector committed

itself to fiscal discipline, and to specified policies for the exchange rate

and public sector prices. As a counterpart there were agreements for wages

and private sector prices. The program was rounded out by an aggressive

trade liberalization.

Key features of the were wage agreements that kept a very

firm lid on wage increases and an exchange rate policy that reduced the rate

of depreciation. Until mid-1990 the exchange rate was depreciated by 1 peso

a day, corresponding to an annual depreciaricn race of about 15 percent.

Subsequently the rate of depreciation was cut to 0.8 pesos a day and most

recently to 0.4 pesos. The exchange rate policy was designed to contribute

to disinflation. Interestingly, it did not lead to overvaluotion, unlike in

the Chilean and many other cases. One rcason was surely that the wage

- 32 -

policy cut decisively into wage inflation. Control of public sector prices,

in some areas at the expense of serious misalignment, similarly centributed

to maintaining low inflation.

The exchange rate and wage policy were sustained by a very tight

monetary policy reflected in exceptionally high realized real interest

rates. Gradually, as the exchange rate policy came to be believed, real

interest rates were allowed to come down. On the budget side a large

primary surplus was maintained throughout.

The combination of high real interest rates and a tight budget put

pressure on growth: until 1989 there was no growth to speak of. But more

recently, largely as a result of declining real interest rates, rising real

wages, and a gain in confidence, growth is picking up.

Seigniorage: Seigniorage revenue has been small since the inauguration of

the but in earlier years after the onset of high inflation amounted

typically to 4 to 6 percent of COP, and to about one quarter of total

government revenues. Seigniorage was especially large in 1982 and 1983, the

years that inflation jumped from the moderate to high inflation range.

Mexico's heavy dependenco on soigniorage through 1984 meant that reduction

of inflation required a large fiscal effort, as indeed was made in the

second half of the l9BOs.25

The Next Challenge: Mexico, like Chile, has succeeded in forming a

consensus around conservative macroeconomic policies and microeconomic

reforms. The next question is whether these policies can be carried a step

further to bring inflation down all the way and sustain a fixod exchange

25We see no evidence that Mexico was in the range of rho Laifer curve whorelower inflation would have brought in more seignioroge revenue.

- 33 -

rate with the US. Mexico did have a fixed exchange rate between 1954 and

1976 and the period is remembered as one of stability and growth. But how

can Mexico get there?

Because of substantial price adjustments in the public sector, and

because of recovery, Mexican inflation toward the end of 1990 was rising to

an uncomfortable 25-30 percent range. These numbers overstate the core

inflation because of a bunching of price corrections undertaken well in

advance of the 1991 Congressional elections. The temptation now might be to

go for broke: fix the exchange rate on the dollar at the current level and

allow the discipline of an open economy to push inflation down. The policy

is tempting, except for the Chilean experience in the late seventies and

early eighties..

Without a new incomes policy agreement, the fixed exchange tate

strategy might be considered outright dangerous. But incomes policy is

already strained after 3 years of pacts. The dilemma then is how to get out

of the gg without renewed inflation and how to make progress on further

disinflation without recession. Probably a fixed exchange tate is the most

plausible mechanism provided imbalances can be financed and the budget is

not allowed to deteriorate. The likely result would be real appreciation.

But some real appreciation can be tolerated if Mexico enters a Free Trade

Agreement with the US and in so doing receives a major credibility bonus.

Colombia

Colombia is the moderate inflation country par excellence: it

entered the moderate inflation range in 1973 and has been thete since, with

the brief exception of 1977 when inflation rose above 30 percent (Figure 1

- 34 -

and Table 11)26 Colombia's growth performance during tbar period has been

good, especially by Latin American standards, and it avoided rescheduling

its debt doting the debt crisis. During this period, 3D petcent has become

a ted line for inflation: policy swings into action when the line is about

to be breached, as in 1977 and 1990.

Table 11: Colombian Inflation and Growth, 1970-78

1970-71 1972 1973 1974 1975 1976 1977 1978

COP growth 6.6 7.6 6.7 5.8 2.1 4.8 4.1 8.4

Inflation (CPI) 10.1* 13.4 2D.g 24.3 22.9 2D.2 33.1 l7.g

Source: COP growth from World Bank, World Tables; CPI from IFS.*

COP deflator for 1970-71

Colombia introduced a crawling peg exchange rate in 1967, as part

of an export-oriented package to revive growth. Despite the crawling peg,

and the introduction of indexation of both deposits and loans in the housing

finance system in 1971, inflation atayed low until 1971. By 1973, Colombia

was in the moderate inflation range, ma were many other countries affected

by the worldwide boom and commodities inflation, which included coffee. But

Colombia waa there to stay, with the assistance of mechanisms for living

with inflation: the crawling peg; indexation of the system of housing

finance; and indexation of tax brackets and the cost basis for asset

taxation, introduced in a 1979 tax reform. The Musgrave Commission, which

reported before the 1974 tax reform, recommended against recognizing the

distinction between nominal and teal returns on assets on the grounds that

this would weaken the political will to fight inflation.

26For accounts of Colombian economic policy, see World gank (1984) , andUrrutia (1989), and Hommes (1390).

- 35 -

At the beginning of the moderate inflation period, in 1974, the

Lopez administration committed itself to reducing inflation to world levels.

It identified the budget deficit as the main source of inflation, and the

lack of tax revenue as the main source of the deficit. It undertook a

fiscal reform, which raised the share of government revenues in GNP. But it

also had to deal with the balance of payments, for which purpose it devalued

by 10 percent. The devaluation created a small increase in inflation, but

the combination of tightened fiscal policy and abating world inflation

brought the inflation rate down during the next two years, to the extent

that by the end of 1976 it would have been reasonable to believe that steady

contractionary pressure would force inflation down to world levels.

However, after 1974, money growth was generally expansionary, reflecting the

government's reluctance to fight inflation with full force.

The jump in inflation in 1977 is associated with a coffee and

external payments boom in 1976, during which coffee prices virtually

doubled, and money growth was allowed to increase. A stabilization program,

tightening fiscal and monetary policy, and slowing devaluation, was put in

place at the beginning of 1977, and by the end of 1977 it had virtually

stopped inflation. The high growth of 1978 derived in part from large

agricultural output increases, as well as strong exports; money growth

continued high as a result of an unsterilized balance of payments surplus.

This is the first of several episodes in which the upper bound of 30 percent

was established for acceptable inflation.

Colombia's economic performance during the period from 19Th to 1982

(the Turbay administration) has much in common with that in the rest of

Latin America (Table 12), in that the government budget moved from a small

- 36 -

surplus in 1978 to a deficit of 7,6 percent of COP, the real exchange rate

appteciated, the current account deteriorated dramatically, and growth

slowed. Both the appreciation and the collapse of coffee prices contributed

to tha worsening of the current account. Although the tax share of GNP

increased during this period, expenditures increased more rapidly. The debt

ro GOP ratio from 28 percent in 1980 to 44 percent in 1985.

Table 12: Colombia: Macroeconomic Performance, 1980-89

Real CPI Ml Budget Current Seignior- RealGOP def. acc. age ER

1980 4.1 26.6 27.9 2.5 0.4 2.8 73.11981 2.3 27.5 19.9 6.1 -6.7 2.4 70.71982 1.0 24.6 25.4 7.6 -11.3 1.7 65.61983 1.6 19.7 29.7 7.5 -10.8 1.7 67.31984 3.4 16.2 23.4 6.3 -7.6 2.0 71.91985 3.1 24.0 28.2 3.5 -4.9 1.4 92.41986 5.8 18.9 22.8 -0.6 1.6 1.7 100.01987 5.4 23.3 33.0 1.9 0.2 1.9 99.71988 3.6 28.1 25.8 2.1 -1.0 1.6 97.71989 3.3 25.9 29.0 1.8 -0.4 1.8 105.01990 3.7 29.1 25.8 0.1 1.0 L3 117.8

* Annual rates of change for first three columns; columns 4, 5,and 6 are percent of GOP, with current account surplus shownas positive; real exchange rate is index with l986l00.

Source: World Bank.

A major adjustment program was undertaken in 1984. The budget

deficit was reduced by nearly 7 percent of GNP over two years, through

increased revenues -- obtained in part through rougher collection,

reductions in public employment, and reduced public enterprise deficits. At

the same time, the rate of depreciation of the exchange rate was sharply

incressed, though there was no step devaluation. The tightening of fiscal

policy moderated the impact of devaluation on inflation. In addition, the

government liberalized imports. The real lending interest rate was

- 37 -

increased, but there is no other sign in the data of a tightening of

monetary policy.

The adjustment program, aided by the recovery of growth in the

world economy, succeeded in reducing the balance of payments deficit to a

sustainable level. Growth increased from 1984, but remained below the rates

of the previous decade.

The main aims of the 1984 stabilization program were to end the

balance of payments crisis and restoregrowth. Both these goals were

achieved. There ia little evidence that the government placed much weight

on the goal of significantly reducing inflation, and inflation did not

decline. Both the rapid devaluation and the continuance of money growth at

previous rates ensured that moderate inflacion would continue.

Seigniorage: Throughout the moderate inflation period, aeigniorage revenue

has accounted for a significant share, on average about 20 percent, of total

government revenues. That share declined during the l98Os, as tax reforms

were implemented and tax collection improved. Inflation stabilization would

require an increase in taxes to offset the decline in seigniurage revenue.

Summary: Since 1985 the Colombian econumy has been hit by a variety of

shocks, particularly to coffee and oil prices, leading to fluctuations in

the balance of payments and inflation, but with fiscal policy being used

actively to prevent inflation rising much above 30 percent.

However, between 1974 and 1990, no government made the reduction of

inflation a high priority, and the economy was well-adapted to living with

inflation. The incoming Caviria administration in 1990 appears more

concerned about inflation than its recent predecessors, perhaps benause the

inflation rate has been uncomfortably close to 30 percent. The new

- 38 -

administration promises a serious attack on inflation, aiming to get the

rate down below 15 percent by 1994. With the exchange rare so depreciated

and the current account and fiscal deficit in good shape, the government has

some room for manouevre. The administration cannot doubt that a

concentrated anti-inflationary policy will temporarily reduce growth, but

expresses the view that reducing inflation is worth the cost.

Brazil

In March 1964 a military coup put an end to the constitutional

populist regime of Joao Coulart. In the preceding few years inflation had

risen from a comfortable 20 percent in the late 1950s to 144 percent, fueled

by money printing, in the first quarter of 1964. The middle class,

threatened by economic instability and tadical rhetoric, supported military

intervention. The coup was followed by more than a decade of political

reptession and an economic miracle.

Disinflation. The Economic Action Program of the new government detailed a

plan to reduce inflation gradually over three years by tightening fiscal

policy and using an incomes policy. Fiscal consolidation teduced the budget

deficit ftom 4.2 percent of GOP in 1963 to only 1 pctcent in 1966. Inflation

came down rapidly to the moderate inflation range (see Figure 5 and Table

13) and without a majot impact on growth.

120

110

100

90

80

70

80

50

40

30

20

10

FIGURE 5

BRAZIL: INFLATION

1860 1962 1884 1866 1868 1870 1972 1974 1Q78 1Q78 1Q80

- 39 -

Table 13 Brazil in the 1960s

1960-63 1964 1965 1966 1967 1968-72

Inflation 45 92 66 41 31 23

Growth 6.9 2.9 2.7 5.1 4.8 12.9

Budget Deficita 3.7 3.2 1.6 1.1 1.7 0.5

seignioragea 54b 5.0 4.7 2.1 1.9 2.0

Seign/RevC 400b 39.3 34.9 18.3 19.8 17.8

apercent of GOP b196263 CSeigniorage/totai government revenue (md-

uding seigniorage) es percentSource: Simonsen (1974), IFS, and Gardoao and Fishlow (1990).

A key aspect of the program was a change in the wage indexation

formula. From an automatic backward-looking mechanism that built in

inertia, the formula was changed to link the current month's wage

settlements, lasting 12 months, to "expected" inflation, i.e. to a

government inflation forecast.27 Simonsen (1986,p.ll8) notes that the new

wage laws were binding, leaving no degrees of freedom in wage setting for

the employers or the employees.

The change in indexation rule operated as a disinflation mechanism

because productivity allowances and inflation forecasts were entirely up to

the government.28 It can be no surprise that these forecasts diverged

sharply from reality: the allowances for 1965-67 were respectively 25, 10,

and 15 percent while the actual cost of living increases over the period

were 46, 41, and 24 percent. As a result real wages declined by 25 percent

27See Simonsen (1986,pp.1lB-l29) and Fishlow (1974).28The exact formula, as reported in Simonsen (l986,p.ll9) was:w — p*l + .55 + .5(w1 - p*l + w2 p*2) +where p* is the cost of living at the end of the year and all variables arein logs except for the inflation forecast, 5e and the productivity growth

allowance z.

- 40 -

in this period.29 In terms of out earlier discussion, the deceleration in

wage increases provided the initial slowdown in inflation. Thus labor paid

for the disinflation process, at least initially.

In commenting on the wage indexation formula introduced to help

4 disinflation, Fishlow (l971+,p.267-8) notes: "Because the central components

of the formula were expectations rather than realizations, wage correction

was in fact not indexed at all. Nominal wage increases could be granted in

any magnitude deemed convenient, simply by assuming the appropriate rate of

inflation."

In Brazil's case, with almost every aspect of policy, including

fiscal policy, pointing in the same direction, it is hard to identify the

key element in the disinflation. Three factors contributed: the change of

political and economic regime and the accompanying repression of labor

militancy; the sharp tightening of the budget; and the change in the

indexation formula that effectively produced a disinflation of costs through

legislation. It is interesting to note that the disinflation did not cause

a recession. However some impact of the disinflation is evident from the

fact that growth was sharply higher both before and after the disinflation

than during the period.

Three other points are worth noting. First, there was teally no

monetary crunch, except possibly in 1966 after disinflation was already well

underway. Table 14 shows Decembet-December growth rates of money and

prices. Money growth remained high in 1965, well above the inflation tate,

thereby permitting the rebuilding of real money balances to a level

29See Simonsen (l986,p.ll9).

- 41 -

consistent with lower inflation. The absence of a monetary crunch in thar

year suggests that fiscal policy, the credibility effects of the military

government, and perhaps most of all the change in the indexarion rule must

be given the credit for disinflation.

Second, there was no attempt to move inflation below the moderate

inflation range. The Brazilian stabilization thus presents an early example

-- and perhaps a warning -- of the type of problem that is being faced at

present by countries like Bolivia, Israel, and Mexico, which have

successfully reduced extreme inflations but not moved below the moderate

inflation range.

Table 14 Brazil: Money and Inflation(December to December Growth)

Money Growth Inflation Real MoneyIndex 1961—100

1962 63.3 51.3 1081963 64.0 81.3 9B1964 85.8 91.9 951965 75.4 34.5 1241966 16.8 3B.6 1041967 42.4 24.3 1201968 43.0 25.4 137

Source: Simonsen (1974)

Third, seigniorage accounted for an important share of total

government revenues in the early 1960s, as the inflation accelerated.

Seigniorage declined as fiscal consolidation took place, but nonetheless

still amounted to over one-sixth of government revenues after inflation

declined. It continued to represent somewhere between 15 and 30 percent of

government revenues through the next decade.

- 42 -

In 1968-70 once disinflation had been put in place, structural

reform helped support the program for growth. The exchange rate regime

became a crawling peg with frequent mini-devaluations. Trade was in some

measure liberalized, by streamlining tariffs and quotas, and by putting in

place a system of duty rebates for exports. Public finance was improved

radically on the side of tax collection: receipts were raised from only 15

percenr of GOP in the mid-60s to almost 25 percent in the early 70s. These

measures helped prolong the boom by preventing the two most common causes of

policy reversals: foreign exchange bottlenecks, and problems of public

finance.

By the early 1970s Brazil had learnt to live with inflation, thanks

to pervasive indexation.30 In fact, there was s certain pride in managing

inflation without tears.31 Thus Simonsen (l974,p.116) notes: "A respectable

current of economic thinking admits today that 15 percent inflation per

year, in the actual conditions of Brazil, represents a situation far less

serious than 5 to 6 percent inflation in a country not equipped to deal with

inflation, that is without pervasive indexation and a crawling peg exchange

rate policy."

Resurgence of Inflation: The reduced inflation of the 19i4-ii stabilization

program was carried into the early l970s. The economic miracle produced

record growth rates with falling rates of inflation. In fact, in 1973

"official" inflation fell to only 12.7 percent and real inflation was not

much higher. Pervasive indexation of wages -- the formula for which had

305ee especially the discussion in Fishlow (1974).31There was a similar attitude to living with inflation in Israel at thattime.

- 43 -

again become backward looking - - and especially of public secror prices and

financial assecs ensured that living with inflation was no problem at all.

In fact, it was so little of a problem that inflation was not taken very

seriously even when it increased to 100 percent.

The key fact is that when inflation came down to 20 percent, and

when public sector deficits and the misalignment of relative prices had been

cured, the doors wete open to an extraordinary boom. And the government was

in no mind to do anything -- such as trying to teduce inflation -- that

could stop the boom. The early l970s, befote the oil shocks, would have

been the time to make the institutional and policy changes that might have

taken inflation all the way down to industtial country levels, but the

problem was not sufficiently pressing for the government to want to make the

attempt.

The resurgence of inflation in Brazil occutted in the mid-l970s in

the context of an ovetheating economy - - the average growth tate fot the

period 1967-74 was 10 percent per year! The oil shock in combination with

backwatd looking indexation - - which causes difficulties in the face of

supply shocks - - rapidly increased inflation. Table 15 shows the pattern of

a doubling of inflation rates every few yeats. A key ingredient in the

speedup was the progressive shortening of indexation intervals.

Table 15 Accelerating Brazilian Inflation

(Period Avetage)

1970-75 1976-79 1980-82 1983-85

21.4 44.3 97.8 188.3

Soutce: IFS

- 44 -

The chief lessons from Brazil's experience concern the roles of

indexation, demand management, and the need to deal opportunely with

inflation. In effect, deindexation of wages was used in the 1964-66

stabilization (in combination with political and wage repression) to sharply

decelerate inflation without creating massive unemployment. But indexation

was reinttoduced, and because it was backward-looking served to accelerate

inflation when supply shocks appeared in the 1970512

Two different types of oppottuniry were missed in dealing with

inflation. First, when conditions wete booming in the early seventies, the

govetnment could have attempted to move the inflation rate down below the

moderate inflation range, without much feat of a recession. And second, as

inflation accelerated in the first oil shock, Brazil could have implemented

policies to try to keep inflation in the moderate range. It did neither,

and inflation later exploded, with consequences that sre still being

suffered.

Korea

Korea has a long inflationary history11, which includes an incteaseof over 2300 percent in the wholesale price index in July and August 1945 as

price controls wete removed at the end of World War It. Inflation returned

to the triple digit range during the Korean War, and, fueled by rapid money

growth, stayed high after the war.

Serious inflation stabilization measutes were taken in 1956, with a

Combined (Korean and U.S.) Economic Board approving an annual financial

120n these mechanisms see Dornbusch, Sturzenegger and Wolf (1990).Cole and Fark (1961), Chapter 8, describe the history of inflation sincethe 1860s.

- 45 -

program that set ceili ,gs for money growth and other financial variables,

including government borrowing from the central bank. inflation fell

rapidly, and was actually negative in 195g. However the reduction in

inflation over this period was accompanied by a decline in real growth until

1960, a factor cited by the miiitaty as justification for the 1961 coup.

The military government that took over in 1961 relaxed monetary and

fiscal policies, brought the Bank of Korea under the legal control of the

Finance Ministry, created new lending agencies, and in 1962 undertook an

unsuccessful currency reform (Coles and Park, Chapter 3). Along with the

expansionary policies, a new forceful industrial policy, increased foreign

aid, reductions in import controls, and a devaluation in 1964 pushed Korea

into its modern growth era, as well as to higher inflation rates - - the

years 1962-64 qualify as an episode of moderate inflation.

Inflation was in the double-digits in Korea in every year between

1963 and 1981, except for 1973 (Figure 5)34 After 1982, the annual

inflation rate was comfortably in single digits. Using the CPI as a measure

of inflation, Korea suffered two spells of moderate inflation tn the period

since 1971: 1974-76, and 1979-81. Measuring inflation by the CNP deflator,

Korea was in the moderate inflation range between 1975 and 1981.

Either way, Korea is one of the few developing countries which has

moved decisively from moderate to low inflation.35 We examine two

341n that year, CPI inflatiod was 3,0%, while the GOP deflator increased13.5%. The deflator typically increased mote rapidly than the CPI; in turnthe CFI usually rose more rapidly than the WPI. This pattern is familiarfrom Japan, and results from the rapid increase in real wages and thus the

price of services.5Korea has also flitted with hyperinflation and extreme inflation in thepost-World War II period. Since the hyperioflation was confined to twomonths, taking the form of a jump in the price level rather than acontinuing process of inflation, we do not regard Korea as one of the tarepost-War cases where a country has moved from hypet- or extreme inflation to

low inflation. -

34

32

30

2B

26

24

22

2000 lB

lB

4

12

ID

B

6

4

2

FTCURE 6

KOREAN INFLATIONCPI and ONP Deflator

a cpt + Deflator

- 46 -

questions: Why was inflation in the moderate range up to 1981? Row did

Korea reduce its inflation rate ao decisively?

Inflation was not a major concern of the Korean government in the

period before the late 19?Os. The 1964 devaluation marked the definitive

atart of the Korean export promotion drive and the modern Korean growth

phenomenon. For the period 1965-71, with growth averaging just under 10

percent and inflation just ovar 10 percent per annuis, there was not much

reason to worry about inflation. Cole and Park (p213) describe 1965-71 as a

Golden Age, to which foreign capital inflows contributed. Despite the

double digit inflation, there was no wage indexation; productivity gains

produced rising real wages in any case. Particularly since it showed no

sign of getting out of control, inflation was not regarded as a policy

problem.

Korea's first moderate inflation episode in the modern high growth

era came with the first oil shock (Table 16). The government responded to

the shock by raising taxes on oil, but otherwise going for growth, expanding

investment, exports (including labor) to the Middle East, and foreign

borrowing. The nominal exchange rate, which had been pegged in 1972, was

devalued by 20 percent at the end of 1974, and fiscal36 and credit policies

were expansionary.

36Corbo and Ram (1990) calculate a full employment deficit, which behaves inmuch the same way as the actual deficit shown in Table K3.

- 47 -

Table 16: Korean Inflation, 1972-77

1972 1973 1974 1975 1976 1977

COP growth 5.9 14.4 7.9 6.5 13,2 10,9

Inflation 021 11.5 3.2 24.3 25.3 15.3 10.2

COP deflator 16.5 13.5 29.5 26.9 20.9 16.4

5(2 growth 33.8 35.9 24.0 28,2 33.5 39.7

Credit growth 29.1 29.6 52.6 32.5 22.7 24.0

Budget deficit 4.6 1.6 4,0 4.6 2.9 2.6

Seigniorage 3.3 3.6 2.0 3.0 2.6 3.5

Nominal exchange rate 6.9 -0.4 21.8 0,0 0.0 0.0

Current a/c deficit 3.5 2.3 10.8 8.9 1.1 -0.0

Nominal wages 17.5 11,5 31,9 29,5 35.5 32.1

Productivity 11.8 8.5 6.3 5.9 7.0 9.9

Import prices: All items 6.9 25.9 40.2 -4.0 3,0 1.2

Petroleum -3,5 18.8 56.1 -8,5 -3.5 -6.6

* Chemicals, petroleum, and coal producteSources: IFS, Major Statistics of the Korean Economy, 1990 (National Bureauof Statistics, Economic Planning Board).

the decision to emphasize growth during the first oil shock was

also a decision not to fight inflation. On the cost side, the jump in

inflation between 1973 and 1974 can be traced to higher import prices, and

to wage inflation. In the absence of restrictive policy, and because

unemployment increased very little, wage inflation continued at 30 percent

in 1975 and 1976. The fixed exchange rate and declining import prices by

contrast tended to reduce the inflation rate,

The growth policy was extremely successful, but the high inflation

of 1974 and 1975, combined with a fixed exchange rate, led to a tightening

of credit in 1976, as well 55 a shift to more restrictive fiscal policy. In

- 48 -

addition, price conrrols were imposed on borh consuaer and producer goods.

Inflation slowed appreciably in 1976 and 1977, while growth increased, but

wage inflation did not decline, in part because of Middle Eastern demand for

Kurean labor. The current account was in surplus in 1977. In 1977, the

Korean approach to the oil shock appeared to be entirely auccessful.

However, after 1977 Korea began to display Latin American symptoms:

the currency was increasingly overvalued37, foreign borrowing waa growing,

and inflation was increasing. There was some tightening of monetary and

fiscal policy in late 1978, but at the same time the heavy and chemicals

industries investment drive pushed the rate of investment above 30 percent

for the first time.

Table 17: Korean Inflation, 1978-84

1978 1979 1980 1981 1982 1983 1984

GD? growth 9.7 7.4 -2.0 6.7 7.3 11.8 9.4

Inflation: CPI 14.4 18.3 28.7 21.3 7.2 3.4 2.3GDP deflator 22.7 19.8 24.0 17.0 6.9 4.9 4.0

M2 growth 35.0 24.6 26.9 25.0 27.0 15.2 7.7Credit growth 45.4 35.7 40,6 31.1 25.1 16.0 13.1

Budget deficit 2.5 1.4 3.2 4.6 4.3 1.6 1.4Seigniorage 3.0 2.1 -0.6 -0.9 1.9 0.4 0.2

Nominal exchange rate 0.0 0.0 36.3 6.2 6.9 6.2 4.0

Current s/c deficit 2.2 6.4 8.5 6.7 3.6 2.0 1.5

Nominal wages 35.0 28.3 23.4 20.7 15.8 11.0 8.7Productivity 11.6 15.3 10.7 16.8 7.3 12.9 10.0

Import prices: All items 4.1 26.6 27.5 2.4 -5.3 -4.2 0.3Petroleuzs* -4.6 47.0 12.8 -4.1 -2.8 -3.3 0.1

*Chemicals, petroleum, and coal products

Sources: IFS, Major Statistics of the Korean Economy, 1990 (Natiunal Bureauof Statistics, Economic Planning Board).

37In 1979, the dollar vslue of Korean exports declined.

- 49 -

For the first time in the modern growth era, inflation became a

central concern of policy. Sang-woo Nam (1984) explains:

Aa inflation accelerated, it became clear that sustained economic

growth is simply impossible without curbing inflation. Weakeningexport competitiveness, unproductive activities of businessespreoccupied with inflationary gains, and the growing frustration ofworkers confronting a widening disparity in the distribution of income

and wealth, all indicated that growth potential was being seriouslyundermined by chronic inflation.

Foremost among the reasons to fight inflation was the labor unrest

caused by the increasing visibility of speculative incomes, especially in

real estate and the stock market. The argument tying export performance to

inflation appears to assume a fixed exchange rate: perhaps it is being

implicitly argued that devaluation would have worsened inflation. In any

case, by the end of the seventies, the Korean government had decided to

fight inflation.

In April 1979, before the second oil price shock, the government

adopted the CMES (Comprehensive Measures for Economic Stabilization)

stabilization program.38 The plan was to cut current government

expenditures by 5 percent, and to cut back on investment.39 Interest rates

were raised and subsidized lending reduced. In addition, a price

stabilization program was announced for necessities, including measures to

expand domestic supply, improve distribution of foodstuffs, and liberalize

imports.

This program was derailed by both the second oil price shock and

the assassination of President Park. The oil price shock added to the

38We draw here on Nam (1984), and on Corbo and Nam (1991, Chapter 5).39Corbo and Nam (Chapter III) show a reduction in the full employmentdeficit of about 1.5 percent of CNP in 1979.

- 50 -

effects of poor harvests in 1978 and 1979 to worsen the balance of payments.

High world interest rates and the deteriorating debt siruation meant that

this time Korea could not go for growth and borrow its way through the

second oil shock. The oil price increase was passed on to domestic prices

directly. There was also a widespread diagnosis that the heavy and

chemicals industries drive of the late seventies had been a mistake, and

that the economy needed trade and domestic liberalization.

Early in 1980, the won was devalued by 20 percent, and shortly

thereafter was tied to a basket rather than the dollar. To counteract the

inflationary effects of devaluation interest rates were increased by 5-f

percent, the loan rate increasing from 19 percent to 25 percent. The

aggregate thrust of fiscal policy was essentially unchanged, but its micro

details changed from supporting heavy industry towards small and medium-

sized firms and residential construction. A poor rice crop and the collapse

of external markets made 1980 the first year of negative growth in over two

decades40, while the price shocks kept inflation high.

There is little sign in Table 17 of a tightening of fiscal and

monetary policies between 1979 and 1982, except for the reduction in

seigniorage revenues. Fiscal policy tightened only in 1981.41 Interest

rates were raised in 1979, money growth declined, but the real volume of

credit expanded in 1980 and 1981. The extra ingredient was incomes policy.

400HP fell by over 5 percent, while CDP fell between 2 and 3 percent. Thedifference can be traced in large part to the impact of the devaluation onthe value of net interest payments to foreigners. The sharp decline inagricultural output alone reduced CNP by 4 percent.4tAll measures of the overall fiscal impulse show a significant tightening,by about 1.5 percent of CNP, in 1981. See Curbo and Ham (1991), Chapter 3,Table 8; and also Aghevli and Marquez-Ruarte (i95), Table 8.

- 51 -

Wage increases in rhe governisenr secror were reduced in 1981, and 1982; by

convenrion, and wirb rhe assistance of jawboning, rhe privare sector

followed. In addirion, a maas educarion campaign, undertaken at the end of

1980, "stressed the need for restraining the demand for excessive wage

increases and for a higher governxsenr purchase price of rice." (Nais, 1984).

Nominal wage growth and inflation continued to decline after 1982,

along with the rates of growth of money and credit; at the aaae time the

Korean growth machine revived. Inflation has stayed low since.

Corresponding to the decline in inflation, seigniorage accounts now fcc only

a small share of government revenues.

It took almost three years from the beginning of the comprehensive

stabilization program in 1979 until inflation came down to the single digit

range. That lag was in large part caused by the massive international

shocks, as well as the domestic agricultural shock, that hit Korea between

1979 and 1982. By any standards -- and especially by Korean standards --

1980 was a recession year. This invites the question of how much of the

recession was due to anti-inflationary policies. To estimate the answer, we

would need both to specify the alternative policy and a model to calculate

the impact. One alternative would have been to accommodate the inflation,

allowing inflation to rise by the extent of the price shocks of 1980. Such

a policy would have produced a smaller recession in 1980, hut we do nat have

a model that would allow us to calculate the tradeoff.42

42Corbo and Nam (1991) present a wage-price model, but it does notexplicitly include monetary and fiscal policy. Unemployment is treated asexogenous, but the estimates of their Phillips curve show small effects of

higher unemployment on inflation.

- 52

Contrasting the results of Korea's econoeic policies in the 1980-82

period with those of Latin American countries that accoemodated the

inflation, it is hard to believe there would have been a significsnt

tradeoff over any long period. It is clear also that the authoritarian

structure of policymaking in Korea significantly reduced the output

sacrifice needed to reduce inflation.

Indonesia

After extreme inflation and a violent revolution in rhe mid-

sixties, Indonesia was growing fast by 1968 and had single digit inflation

by 1971 (Table 18 and Figure 7)43 The stabilization was orthodox, with

both the budget deficit and monetary growth being reduced

Table 18: Indonesian Inflation and Growth, 1965-72

1965 1966 1967 1968 1969 1970 1971 1972

COP growth 0.0 2.3 2.3 11.1 6.0 7.5 7.0 9.4

Inflation 596 636 111 84 10 9 4 26

Source: ON? growth from IFS; inflation rate is year-end to year-end changein Jakarta OPI, from Gillis (1984), p.237.

rapidly.44 The restoration of real balances after the hyperinflation,

financial reform, and growing monetization in Indonesia in the period of

rapid growth, permitted money growth rates well in excess of the rate of

43Both ON? and inflation data for this period are of poor quality; the CPIis based on Jakarta prices, but there are frequently large differences ininflation rates in different parts of the country.44For descriptions of the Indonesian economy, see Glassburner (1971),Papanek (1980), Booth and McCawley (1981), Gillis (1984), Gelb andGlassburner (1988) and the regular reports on recent economic developmentsin the Bulletin of Indonesian Economic Studies.

340

320

300

280

250

240

220

200

80

I 50

I 40

120

I 00

80

60

40

20

0

FIGURE 7

INDONESIAN INFLATIONIPI

- 53 -

growth of nominal UN? after 1968, and meant that seigniorage typically

accounted fot about 15 percent of total government revenuem. In the early

stages of the stabilization, until the end of 1968, the exchange rate

floated; it was then pegged to the dollar, but with large devaluations in

1970 and 1971. Remarkably, capital movements were freed, and have remained

free since 1970, despite an adjustable peg exchange rate.

Strictly speaking, Indonesia has not experienced any episodes of

moderate inflation in the period since 1972. In the firmt oil price shock,

inflation was above 30 percent for 1973 and 1974, and around 20 percent in

1975 and 1976; inflation was lower in the second oil price shock, in the

moderate range for only two years. Given its inflationary history, it is

easy to imagine that Indonesia could have gone into a prolonged inflation as

a result of the oil price shocks; we study the first oil shock episode to

discover how it avoided the inflation trap.

Because it is an oil exporter, Indonesia's budget benefitted

Table 19: Indonesia: the First Oil Shock*

Real CPI M2 Credit Budget Seignior- CurrentCOP def. age scc.def.

1972 9.4 6.5 48.6 33.7 2.7 2.7 3.01973 11.3 31.0 41.6 64.7 2.5 2.3 2.91974 7.6 40.6 40.4 41.3 1.6 2.9 -2.31975 5.0 19.0 35.2 47.6 3.9 2.2 3.61976 6.9 19.9 25.7 18.5 4.6 1.6 2.41977 8.8 11.1 25.3 45.2 2.1 1.8 0.21978 7.8 8.1 24.0 4.5 3.5 0.7 4.5* Annual rates of change, for first four columns; last three

columns are as percent of CD?.Source: IFS

from the oil price increase (Table 19). It is clear from the table that in

Indonesia, as such of the rest of the world, inflation was on the rise

- 54 -

before the oil price shock, which hit only at the end of 1973. Increasing

rice pricea, a result of rising import prices, inefficient domestic

procurement policies, and a poor domestic crop, were a major factor in the

1973 inflation.45 Rising export prices, the boom, and accommodating

monetary policies, added to the inflation.

Indonesia is distinguished from other oil exporters by its

relatively careful budget policies.46 The budget deficit was not allowed to

rise above 5 percent of GNP, even in l97i when the real price of oil was x%

below ita 1974 level. Equally important, Indonesia used the oil windfalls

mainly to finance investment spending. Thus while government spending was

pro-cyclical, it was the investment component that fluctuated most.

A major stabilization program was initiated in April 1974. The

monetary measures were conventional: interest rates were raised, reserve

requirements doubled, foreign borrowing was taxed, and credit ceilings were

imposed47. Fiscal measures were more complex: sales taxes on luxuries were

raised while those on essentials were reduced; imports of rice and

fertilizer were heavily subsidized; and it was decided to aim for a budget

surplus (Atndt, 1974). Although Indonesia did nor achieve a budget surplus,

the deficit never rose our of control, and dependence on seigniocage was

reduced.

45This episode is discussed in McCawley (1973).46cillis (1984) interprets the balanced budget rule that has been aprinciple of policy followed by the long-lasting Indonesian economic team.7A 30 percent non-interest hearing deposit at the central bank was imposed

against private sector foreign borrowing except for financing imports andfor long-term borrowing.

- 55 -

In 1974, Perraaina, the national oil company, which had borrowed

extensively and - - to avoid government consttaints -- short-term, was unahie

to iervice its debts. The government assumed the debts and allocated nearly

half of one year's oil revenues to their service, thereby in effect using

oil revenues to increase net forefgn assets, at the time when real oil

prices were close to peak.

The anti-inflation policy implemented in 1974 gradually rook effect

during the next two years, although a budget surplus was not achieved. by

1978 the inflation rate was back to single digits. However, rhe real

exchange rare had appreciated since 1973, and a major devaluation was

undertaken in November, both to improve incenrivea for non-oil exports, and

to increase the rupiah value of government oil revenues. This devaluation

set off another round of inflation, but careful macroeconomic policies kept

inflation at l percent in 1979 and 1980, close to 10 percent rhrough 1984,

and in single digits since then.

The Indonesian experience shows a government that both brought

hyperinflarion under control and prevented prolonged moderate inflarion by

following mostly orrhodox monetary and fiscal policies, with some supply

side fiscal elements thrown in. No doubt Indonesia benefirred from being an

oil exporter, but as Mexican experience shows, being an oil exporter was not

sufficient to avoid the inflationary virus. There was a alight slowdown in

growth in 1975 as inflation declined, but essentially Indoneaia was able ro

maintain high growth rates even while inflarion came down.48

48 1982 and 1985 rhere is some sign that counrer-inflarionary policyhelped reduce growth - - rhough growth has nor fallen below 2 percent per

annum in the period since 1966.

- 56 -

Ire'and

Ireland's inflation entered the double digit range during the first

oil shock. Increased oil prices and a tight link to the collapsing pound

were the main sources of higher inflation. The chief mechanism for

translating supply shocks into increased inflation were sticky real wages.

"National Wage Agreements' and "National Understandings' did more to protect

real wages and relative wages than to help absorb real shocks withouc

sharply raising inflation. The situation was aggravated by substantial wage

gains in the public sector, which made it difficult for the private sector

to resist wage inflation. Moreover, exchange rate policy was broadly

accommodating. Rounds of inflation were followed by depreciation. And

inflation accelerated sharply, reaching more than 20 percent in 1981-82 (see

Figure 8).

Having pegged to sterling since 1922, Ireland abandoned the

currency link with the U.K. and joined the EMS in 1979. Until the early

1980s the EMS had relatively little effect: frequent realignments were

needed because the inflation differentials with Germany and other EMS

partners were substantial. In fact, there were 7 EMS realignments in the

1980-84 period. But increasingly the EMS became core of a constraint, Ot at

least was used as such by policy makers. Early 1982 marks the first case of

an EMS realignment in which the Irish pound was not devalued (in terms of

the ECU). The exchange rate peg became progressively firmer (see Figure 9).

A first factior in disinflation was the decline of external

inflation. Specifically, Ireland's main trading partners, Great Britain,

continental Europe and the US saw a major decline in their inflation rates,

FIGURE R

IRELAND: INFLATION(CPI, 4 qrt.r rut.)

¶971 1973 1975 1977 1979 1Q81 1983 1985 1987 1889 1991

1.52

'.5

.48

.46

1.44

1.42

1.4

1.38

1.36

1.34

.32

'.3

1.28

FIGURE 9

IRELANO: EXCHANGE RATE

0 ECU exchcnge rote

1979 1981 1983 1955 957 1989

- 57 -

continental Europe and the US aaw a major decline in their inflation rates.

Given the fixed exchange rate, declining foreign inflation tended to reduce

inflation in Ireland. But most of the work was clearly domestic. There was

a deciaive turnaround on the budget in 1982: after one government fell on

the budget issue, the new government returned the same budget and got it

passed. Increasingly the view that fiscal discipline and stable exchange

rates were essential ingredients for macroeconomic stabilization gained

acceptance. Tight money supported the move to lower inflation.

Inflation stabilization did not come cheaply. As Table 20 shows,

the unemployment rate rose from 9.5 to more than 17 percent between the

early 1980s and 1987. A massive shift in the primary budget from a deficit

of 4-S percent to a surplus of 4 percent was behind the sharp cooling off in

economic activity.49 And the fiscal tightening was accompanied by a major

increase in realized real interest rates, as a result of both declining

inflation and tight money. With a stable exchange rate, budget tightening

and increased real interest there could be no crowding-in. Unemployment

was the result.

Table 21 Ireland's Stabilization

Inflation Unemploy- Budgets Seignior- Real int-sent age erest rate

1980-82 18.6 9.5 7.g 0.8 -1.7

1983-85 8.1 ls.g 4.3 0.8 4.7

1986-88 5.2 17.5 -0.9 0.5 5.9

1989-90 3.5 14.8 04b3.1 13.9 -4.5

aprimary budget deficit b1989 c0ECD forecastSource: OECEJ and IFS

49Seignicrage revenue was small throughout, suggesting that seigniorsgecannot have been a significant factor underlying inflation in Ireland.

- 58 -

But the unwavering commitment to disinflation did pay off:

inflation came down to German levela by the end of the 1980s, after almost

10 years of disinflation. Even then, unemployment remained high and helped

reinforce the anti-inflationary discipline of monetary and fiscal policy.

There is an interesting question to which no definitive answer is

as yet available: did EMS participation help disinflation, over and above

what monetary and fiscal policy accomplished?50 There is no ready evidence

of the kind a clear-cut, irreversible change in regime might produce, such

as an immediate drop in long term interest rates reflecting a collapse of

inflationary expectations. Rather, disinflation was a day-by-day affair and

the question whether the currency would be devalued was always alive when

EMS realignments came up. There is certainly a plausible claim that EMS

membership helped secure the disinflation: without the EMS commitment, the

government might at a number of points been more inclined to accommodate

inflationary pressures or relent in its restrictive policies -- in brief,

the EMS commitment served as a nominal anchor for policy.

This claim may well be right, but it must nor obscure the basic

message: through 1988, Ireland spent nearly a decade with record

unemployment despite an extraordinary shift in monetary and fiscal policy

While Ireland undoubtedly iii4 change the policy regime, there was no obvious

credibility bonus for the government.

The Proeramme for National Recovery. By 1987 inflation had come down

subsranrially, but the cost in terms of unemployment was extremely high.

50This is the argument Eremers (1990) advances and supports.

- 59 -

The Programme for National Recovery (PNR) was intended to substitute incomes

policy for unemployment as a means of further disinflation. To keep

inflation low, exchange rate depreciation had to be avoided, but inflation

was still too high to sustain a fixed rate indefinitely. The PNR addressed

this issue by an agreement between the Irish Congress of Trade Unions and

the Federsted Union of Employers, which cut rates of wage increase in half.

These pay agreements were widely followed in private settlements. A 1989

survey showed that 97 percent of agreements were within the guidelines and

that 78 percent of these agreements coverad a 3 year period. In the public

sector the pay agreements paralleled those for the private sector, except

that they included a front-end 6 months pay pause.

Thus at the end of the 1980s incomes policy became a powerful means

of combining lower inflation with economic recovery. Exchange tate policy

fully supported the incomes policy: the exchange rate on the DN suffered no

further realignment so that Ireland now had a hard currency. In 1988 it

seemed questionable whether the policy could be called successful.51

Unemployment was extremely high, teal interest rates remained very high and

the debt to CUP ratio was steadily climbing. By 1991 it was quite clear

that Ireland had indeed tutned the corner: growth was strong, inflation

continued to be low and a consensus had formed around the new mactoeconomic

policies.

In the l970s Spain had to grapple with the economic implications of

the advent of democracy, the introduction of modern labot market

51For a highly pessimistic assessment of Ireland's prospects, written at the

trough in 1988, see Dornbusch (1989).

- 60 -

institutions, and with the oil shocks. As a result, in 1977 inflation

teached 25 percent. (See Figure 10). Social agreements combining politics

and the labot market started with the Moncloa Agreements in 1977.52

Since then disinflation in Spain has brought into play the full

range of instruments, from incomes policy to tight fiscal management, tight

money, trade opening and a teal appreciation (See Table 22) . Joining the

EMS in 1989 represented what was hoped to he the final measure to lock in

disinflation.

Table 22 Spanish Macroeconomic Indicators

Inflat- Real inc. Priaar Seignior- Real Unemp. Employ.ion ratea budget ageb FRY rated growth

1979-82 15.3 1.5 2.4 100 12.21983 12.1 7.4 -4.2 nae 91 17.01984 11.2 4.0 -4.1 0.9 96 19.7 -1.81985 8.8 2.2 -4.5 0.8 98 21.1 -0.91986. 8.8 2.5 -3.0 1.5 97 20.8 2.21987 5.2 6.2 -0.5 4.9 100 20.1 3.11988 4.8 4.6 -1.0 1.4 104 19.1 2.71989 i.8 6.3 .0.1 3.1 109 16.9 2.21990 6.7 7.5 -0.9 116 1.2

aRealized teal T-bill tate bpercent of GOP clndex l980-82100 dOEGO measure ofthe standardized unemployment care echange in data series.Source: IFS, OEGD and Morgan Guaranty

It is difficult, as in the case of Ireland, to disentangle which of

the policy instruments played the dominant role. It is clear from Table 22

that unemployment was certainly a major factor, however imperfectly the

unemployment rare measures slack in the labor market. With high growth of the

labor force, negative or moderate rates of employment growth directly add to

unemployment. But care must be taken in using the unemployment tate alone as a

52See especially Blanchard and Bentolila (1990), Coticelli (1990) and Jimenoand Toharia (1991).

FIGURE 10

SFAIN: THE INFLATION RATE

1973 1975 1977 1979 1981 1983 ¶985 1987 1959 1991

- 61 -

measure because of important changes in the structure of the labor market,

notably significantly rising female labor force participation.

The rise in unemployment is not difficult to understand: monetary

policy tightened very sharply with a shift, paralleling that in other

countries, to realized real interest rates on Treasury bills from 1.5 percent

in 1979-82 to more than 5 percent on average in the 1983-90 period. After

1985-86 a sharp tightening of fiscal policy reinforced the disinflationary

stance of aggregate demand policies. Exchange rate policy also shifted to an

unaccommodating stance in 1985 when the sustained real appreciation started.

Observers of Spain's disinflation place importance on the neo-

corporatist industrial relations structure.53 The basic proposition is that in

a centralized industrial relations setting which involves joint bargaining

among firms, the government and labor, better tradeoffs between inflation and

unemployment can be realized than in a Less structured setting where essential

coordination issues go unresolved. In Spain's case explicit wage agreements as

part of the concertacicn social were particularly important in the period 1985-

86. Specifically, the wage agreements provided for a sharp reduction in the

rate of wage increase below the level of inflation in the preceding year, thus

making it possible to push disinflation ahead, as in equaricn (9a) . The cut in

real wages, as a result of unemployment and wage agreements, thus serves as the

disinflation mechanism.

535ee Coricelli (1990) and Jimeno and Toharia (1991),

- 62 -

Table 23 spain: Wage Contracts end Inflation

Wage Inflation

Contract Current Laat Year

1983 11.4 12.1 14.4

1984 7.8 11.2 12.1

1985 7.9 8.8 11.2

1986 8.2 8.8 8.8

1987 6.5 5.2 8.8

1988 6.4 4.8 5.2

1989 6.7 6.8 4.8

Wage agreements were supported by a disinflation strategy involving

exchange rate management and on the trade side. Figure 11 shows the real

appreciation of the peseta since 1985. The progressive opening of trade

required by Common Market membership created import competition that along with

the exchange rate commitment increased domestic disinflationary pressure.

Although there is debate about the significance of the Spanish

unemployment data, there is little doubt that Spanish disinflation, like Irish,

involved a long hard slog. There was a sharp rise in unemployment as Spain

moved out of the moderate inflation range in the early l980s, and then

prolonged high unemployment as the inflation rate was brought down to European

levels. The exchange rate commitment no doubt helped maintain the resolve of

the Spanish government, concerracion made the need for coordinated price and

wage inflation reductions explicit, but they did not make possible a

disinflation without tears.

IV. CONCLUSIONS

Most of the countries whose experiences are studied here, reached

moderate or high inflation as a result of external, and particularly commodity

price, shocks. Those countries that remained in the moderate inflation range

after arriving there, notably Colombia and Chile, and for a shorter time

- 63 -

Mexico, did so only by taking decisive action to prevent inflation from rising

at certain specific points. Brazil, which was not willing to slow growth to

stay in the moderateinflation range, found itself as a resolt with high and

sometimes extreme inflation.

Three of the countries that successfully disinflated to low

inflation, Ireland, Korea, and Spain, did so at a significant output cost.

Each of those countries used non-market measures, the equivalent of an incomes

policy, to assist the disinflation. In the Korean case, wage growth was

restrained through restraint over public sector wages and moral suasion on the

private sector. Even in the Indonesian case, subsidization of rice constitutes

an unorthodox incomes-type policy. There is little evidence in the data that

the Indonesian disinflation imposed significant output costs.

Each of the disinflations was accompanied by a very strong fiscal

contraction. Fiscal contractions were undertaken also in the Chilean and

Mexican cases to reduce high inflation to the moderate range, and in Colombia

to keep inflation moderate.

Countries in the moderate inflation range typically had flexible

exchange rates. The European disinflators, Ireland and Spain, used an exchange

rate commitment as part of their disinflationary strategy. Mexico likewise

relied on an exchange rate anchor in bringing down high inflation. None of the

evidence reviewed for this paper, nor evidence in other studies, establishes

firmly that the exchange tate commitment significantly reduced the costs of

dis inflating.

Indexation and disindexation appears to have played an important role

in the Latin Aisetican inflations and disinflations.54 In Mexico, in the

54In Italy (not reviewed here), disindexation of wages played a criticalrole.

FIGURE 11

SPAIN: THE REAL EXCHANGE RATE(lND 1go—2—OO)

70 72 74 76 76 80 82 84 86 88 90 92

- 64 -

context of the pacto, the departure from backward-looking pay increasea waa an

easential part of the stabilization.

Colombia in effect decided to live with inflation by permitting the

introduction of indexation. Neither Korea nor Indonesia used indexation

widely, and nor did Spain or Ireland. Whether diainflation is easier in the

abaence of indexation, or whether the abaence of indexation indicates a

government's commitment not to live with inflation, is difficult to aay at this

point.

Seigniorage revenuea accountod for a aignificant shace of government

revenues in most of the moderate inflation countriea. Seigniorage waa

especially high at the atart of most of the inflationary epiaodea. This

affected the fiscal effort that had to be made to reduce inflation, but there

is little evidence in the literature that seigniorage considerations played an

important role in the thinking of any government. This absence may reflect a

general lack of understanding of the inflationary process, or may rather mean

that seigniorsge is rarely an explicit reason for a government to pursue

inflationary policies. We believe rhe latter interpretation.

In summary, countries typically find themselves in moderate or high

inflations as a result of external shocks. It takes explicit counter-

inflationary policies to prevent inflation from rising when the next

inflationary shocks hit, so that moderate inflation is not a state in which

economies stay without a government commitment to prevent further increases in

inflation. Covernments have successfully reduced moderate to low inflations,

through a combination of right fiscal policy, incomes policy, and generally

some exchange rate commitment. But there is unfortunately little encouragement

- 65 -

in these case studies for the view that an exchange rate commitment, or incomes

policy, allows a country to move at low cost from moderate to low inflation.55

APPENDIX

Table A-i Experiences of Moderate Inflation(15 to 30 Percent for at Least 4 Consecutive Years)

Country Period Avg. in Period Avg. Before Avg. After

Iceland 1986-90 20,9 48.6 -

Italy 1974.77 17.8 7.1 16.0

Spain 1974-80 19.8 9.3 13.7

UK 1974-77 18.2 8.6 13.2

Seychelles 1972-75 20.6 14.9 13.8

Zaire 1972-75 22.0 6.7 66.0

Mayanmar 1987.90 21.6 6.9 -

Greece 1979-87 20.7 12.7 15.6

Poland 1983-87 19.0 43.8 468.2

Portugal 1974-85 22.7 0.7 10.2

Turkey 1956.59 19.0 13.1 1.6

1973-77 19.0 11.4 71.4

Yugoslavia 1971-75 19.3 7.9 13.1

Bahrain 1974-78 19.3 8.4 5.8

Egypt 1986-90 20.5 15.0 -

Iran 1980-83 20.8 16.5 11.8

1986-89 24.5 12.2 6.5

Israel 1987-90 18.3 242.2 -

Argentina 1962-65 25.7 20.7 25.7

Bolivia 1987-90 15.3 4435.8 -

Brazil 1968-72 20.7 45.9 23.1

Chile 1965-68 24.3 46.0 27.6

1983-87 23.5 21.6 18.9

Colombia 1973-76 22.1 9.7 25.2

1978-90 23.4 25.4 -

Costa Rica 1987-90 17.8 13.0 -

El Salvador 1987-90 22.0 21.9 -

Grenada 1977-81 19.6 - 6,5Mexico 1974-81 21.7 7.4 75.4

Paraguay 1954-57 22.4 74.7 8.1

Source: IFS, various issues.

55We say 'little' rather than "no" encouragement because Indonesia in factstabilized at apparently low cost. Indonesia's governmental structure,level of economiC development, and the relative unimportance of industry,mean that the precedent is not especially relevant to more industrialized

and developed economies.

- 66 -

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